What the financial system does, and what makes it work well

Six reasons people use the financial system

Whenever someone swaps one asset or contract for another, the financial system is at work. 'People' here means anyone acting for themselves or an organisation: households, companies, charities and governments. In a voluntary trade both sides expect to be better off.

Saving moves money from today to the future: a worker buys bonds or fund units to fund retirement. Savers who commit money to earn a return are investors, and they want a fair return that pays for the use of their money and the risk of loss or inflation. Borrowing does the opposite, pulling future income into the present through loans, mortgages, bills and bonds. Lenders charge more when repayment is doubtful, so borrowers often pledge collateral.

Raising equity capital is another way to bring money forward: a company sells ownership shares now in exchange for uncertain future distributions. When a project is too risky for lenders, equity investors may still fund it if they expect valuable cash flows.

Managing risk means trading contracts that offset a risk you already have, such as a grain grower and a miller agreeing a price today for a later delivery. Exchanging assets for immediate delivery covers spot trades like converting dollars into euros or buying gold. Information-motivated trading means trading because your research says a price is wrong.

Investors, information-motivated traders and hedgers

What separates these groups is motive and expected return, not holding period or risk. A bank treasurer parking cash overnight and a pension fund buying shares for 30 years are both investors: each moves wealth forward in time and expects only the fair, risk-adjusted return.

Information-motivated traders expect a return above the fair rate because they believe their information or models predict prices better than others can. Active managers are the classic example. They hope prices move their way quickly so they can close out and redeploy capital.

The labels overlap. Many investors also research securities to beat their asset class; if they have rational grounds to expect superior returns, they are information-motivated traders too. If they never succeed, they would have been better off holding a diversified portfolio.

Hedgers trade to reduce a risk they already carry, such as a manufacturer selling copper futures against its copper inventory. They are not trying to earn more than a fair return on the hedge; they want the risk gone.

Ask 'why is this person trading?' If the answer is 'to save', it is an investor; 'because I know something', an information-motivated trader; 'because I already have this risk', a hedger.

Three functions: purposes, interest rates and capital allocation

The system's first function is simply to help people achieve the six purposes. The second is to determine rates of return. Savers move money forward, while borrowers and equity issuers move it back; because the same bond a saver buys is the bond a borrower sells, the two flows must be equal.

If the expected return is high, savers offer more money and borrowers want less; if it is low, the reverse. The rate at which aggregate saving equals aggregate borrowing is the equilibrium interest rate, the price of moving money through time. Actual required returns are this common rate plus adjustments for risk, term and liquidity: equity above debt, long-term above short-term, illiquid above liquid.

The third function is capital allocation efficiency. In the primary market, companies and governments raise funds. An economy is allocationally efficient when funds go to the most productive projects. Savers decide this directly (by choosing securities) or indirectly (through intermediaries), and their fear of losses pushes them to fund projects whose value exceeds their cost.

Allocation works only as well as the information behind it. If investors overestimate a project, wealth-destroying projects get funded; if they underestimate one, good projects go unfunded.

What a well-functioning financial system looks like

In a well-functioning system, investors can move money forward at a fair return, borrowers with credible repayment plans can get funds, hedgers can offload risks cheaply, and traders can swap currencies or commodities they need.

Three terms describe it. Markets are complete when the assets and contracts people need to solve these problems exist. The system is operationally efficient when trading costs (commissions, bid-ask spreads, price impact) are low, that is, when markets are liquid. Prices are informationally efficient when they reflect all available information about fundamental values, so they move on news rather than on uninformed traders' liquidity needs.

Intermediaries build these markets: they run exchanges and brokers, supply liquidity, securitise assets, take deposits and lend, pool insurance risks, give advice, and run clearinghouses and depositories (lesson 4 covers each). Timely corporate and government disclosure supports informational efficiency.

Informational efficiency is a by-product of operational efficiency. Informed traders push undervalued prices up and overvalued prices down, but only if trading is cheap enough to make their research pay. Informative prices then steer resources to their best uses, which is allocational efficiency. Economies with weak systems keep finance within families, allocate capital badly, share risk poorly and tend to be poorer.

• Complete markets: the instruments people need exist.
• Operationally efficient: liquid, low trading costs.
• Informationally efficient: prices reflect fundamental values.
• Allocationally efficient: resources flow to their most valuable uses.

Objectives of market regulation

Regulators aim for fair and orderly markets where people trade at prices that reflect fundamental values without excessive costs. Markets alone cannot always achieve this, because customers are often far less informed than the professionals serving them and learning enough to protect themselves is costly.

Fraud thrives in complex markets with information gaps. More money is probably lost to agency problems: customers cannot easily tell whether an adviser or manager is skilled, lucky, lazy or quietly favouring himself. Regulators set minimum competence and practice standards; CFA Institute contributes through the CFA Program and GIPS.

Rules against insider trading level the playing field: if insiders kept winning, other traders would withdraw and liquidity would dry up. Common reporting standards (IASB, FASB) let analysts compare companies. Minimum capital requirements ensure firms can honour commitments and that owners have enough at stake to avoid reckless risk. Insurers and pension funds must hold adequate reserves for long-term promises.

Many regulators are self-regulating organisations (SROs), such as exchanges, clearinghouses and dealer associations. Members may submit voluntarily, or governments may delegate authority to the SRO under the supervision of a government agency. When regulation fails, savers stop saving, good projects go unfunded and hedgers withdraw.

• Control fraud.
• Control agency problems.
• Promote fairness (e.g., ban insider trading).
• Set mutually beneficial standards (e.g., financial reporting).
• Stop undercapitalised financial firms from taking excessive risks with investors' money.
• Make sure long-term liabilities (insurance, pensions) are funded.

Regulation is not about guaranteeing anyone a return. It exists because policing these behaviours through private contracts is too costly for unsophisticated, poorly informed customers.